Rich bond yields you’re likely missing

Emerging markets gain popularity with income investors

JonnelleMarte

A grocery store in Mumbai, India. Bond investors increasingly view India and other emerging markets as less risky.

NEW YORK (MarketWatch) — Once viewed as a risky fringe investment, emerging-market bonds now seem one of the safest bets in fixed income.

Investing pros say the credit and political risks that once made them wary of bonds from China, Russia, Brazil and other developing economies are being overshadowed by a potentially greater threat: low interest rates in developed economies.

And many emerging-market countries are also reducing their debt burdens at a time when rising debt levels cast a pall over some developed regions such as Europe.

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Investors poured $20 billion into emerging-market bond funds last year through November (the most recent data available), almost double the $12.5 billion that flowed into the funds in 2011, according to investment researcher Morningstar Inc.

Those buyers have been rewarded: emerging-market bond funds gained close to 18% in 2012 — the best-performing fixed-income category Morningstar tracks.

Fund firms, meanwhile, are responding to the demand by launching new emerging-market bond offerings. Around 20% of the 70 funds in the category were launched last year alone, when total assets in the group hit $75 billion, a 60% increase from a year ago.

Yield signs

Some investors say emerging-market bonds are one of the most attractive places for capturing more yield at a time when the Federal Reserve’s bond buying program, intended to boost the U.S. economy, is lowering yields on domestic bonds across the board.

With an average 4.4% yield, emerging-market bonds currently sport a yield advantage of around 2.5 percentage points over 10-year Treasurys. This yield cushion also suggests that emerging-market bond prices would drop less than Treasury bond prices should interest rates rise, says Fran Rodilosso, co-manager of the $1.1 billion Market Vectors Emerging Market Local Currency Bond ETF
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. (Holders of long-term Treasurys, for example, recently saw a year’s worth of yield wiped out in a week after yields rose slightly, the Wall Street Journal reported this week.) Read more: Long-term Treasurys lose in volatile week.

And emerging-market bonds, which are often denominated in the local currencies of the countries they were issued in, also appeal to investors worried that the Fed’s quantitative easing programs might create long-term weaknesses for the U.S. dollar, says David Falkof, a mutual fund analyst at Morningstar.

That’s not to say that these bonds are immune from the issues plaguing most of the bond market. Yields on emerging-market debt are shrinking along with other bonds as investors pile into the market. The average yield on the JPMorgan EMBI Global Diversified Index, a popular benchmark for emerging-market bond funds, is now 4.4%, down from 5.8% in December 2011 — and half of the average 9% yield the bonds offered at the end of 2008, according to JPMorgan data.

Brian Rehling, chief fixed income strategist at Wells Fargo Advisors, says rising prices and declining yields has left emerging-market bonds with less upside potential. “Given the price runup, we’re kind of cautious,” says Rehling, who recommends that most investors allocate no more than 6% of their portfolios to these bonds.

Similarly, the rush into the funds could also backfire if investors look for a quick exit, critics warn. Indeed, emerging-market bonds sold off at the end of 2011 on heightened fears about the European debt crisis, says Anthony Valeri, fixed income strategist for LPL Financial. “Those flows can also shut off in a moment’s notice,” adds Valeri, who allocates roughly 5% to 10% of his client’s portfolios to emerging-market bonds.

Improving quality

But fans say these bonds are not in bubble territory. The drop in emerging-market bond yields over the past several years has been paired with an improvement in the credit quality of the bonds, meaning that investors are getting compensated less because they are taking on less risk, points out John Higgins, senior market economist at Capital Economics.

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The average credit rating of the JPMorgan EMBI index rose to BBB-, the lowest rating for investment grade bonds, from an average below-investment grade “junk” rating a few years ago. And the yield advantage the bonds have over Treasurys is still greater than the 1.5 percentage point spread the bonds had in May 2007, meaning yields have room to come down further, Higgins wrote in a report published Wednesday.

Still, even some supporters are being more specific about their exposure. Michael Mata, manager of the $815 million ING Global Bond Fund
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, is adding selectively to emerging-market corporate bonds instead of government bonds. Since the corporate issues offer slightly higher yields than similarly rated corporate bonds from the U.S., Mata says they are a way to boost yields without taking on greater credit risk.

Companies in developing countries are also issuing new bonds at a record pace, meaning demand for the bonds could increase at a time when issuance of U.S. corporate bonds is starting to slow, says John Lonski, chief economist for Moody’s Analytics.

Morningstar has two “gold-rated” funds in the emerging-markets bond category. Investors interested in emerging-market corporate bonds may consider the $7.9 billion Pimco Emerging Markets Bond Fund
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, which invests chiefly in dollar-denominated bonds and has a 12% stake in emerging-market corporate bonds, Morningstar’s Falkof says. The fund has gained an average of 11% annually over the past three years, compared to a 5.9% return for other emerging-market bond funds, according to Morningstar.

The other gold-rated choice, the $14.4 billion Pimco Emerging Local Bond Fund
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, may appeal to investors looking to diversify their currency exposure. While local currency exposure increases the volatility of the fund, manager Michael Gomez controls risk by sticking to bonds from investment-grade countries including Brazil, Mexico and South Africa, Falkof says. The fund has returned an average 8.7% a year over the past three years.

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